How I Analyze And Value Stocks

Special note: This is going to be a very long article, but I didn't want to break it into two pieces. I wanted to put something very special together here for you readers, but it may take some time both to read it all and absorb it. I really hope you enjoy.

I've been investing in dividend growth stocks for four straight years now - starting in early 2010 with $5,000 in my checking account and dreams of financial independence.

I now sit here in a plush seat of validity as I watch my six-figure portfolio filled with equity in 43 high quality businesses that have lengthy track records of raising dividend payouts continue to spit out more and more income with which I use to further build my compounding snowball with the power of reinvestment.

So obviously I'm a huge fan of the dividend growth stock investment strategy. In fact, if there were a fan club for dividend growth investing I'd probably be Chairman of the Board.

However, just because I'm a big proponent of purchasing equity in high quality companies that pay out rising dividends doesn't mean I'm interested in slivers of these businesses at any price. Valuation is paramount, and as such to be a successful investor you'll want to make sure you're able to determine the fair value of stocks and purchase at or below whatever you determine fair value to be.

And today, I'm going to discuss how I analyze and value stocks. I don't have a proprietary system or anything like that, but I do tend to follow the same steps, or guidelines, every single time I look at a company as a potential investment. Valuing stocks is part art and part science. I'll first talk about the science side that uses hard numbers, and then follow up with the art side which is more nuanced.

I split my analysis into two separate phases.

Part I - Quantitative Analysis

First, I look at the quantitative aspects of a company. These are the fundamentals; things that can be quantified. So, I'm looking at numbers, percentages and rates.

When performing quantitative analysis I'm looking at a lot of hard data. I'm looking at a company's balance sheet, its income statement as well as cash flow statement. I'm typically using the last 10 years of data when investigating these numbers, because I feel 10 years allows business cycles to smooth out over time.

Growth Rates

It's during this phase that I calculate the compound annual growth rate of important metrics like revenue, earnings per share and dividends per share. Although I don't have specific growth rates in mind, I typically want to see at least mid-single digit growth in these numbers over the course of a decade or so. However, it's important to compare a company's growth rate against other companies in its competitive space. For instance, comparing how a medical device company grows revenue and EPS against a tobacco company wouldn't make any sense. So once I determine how much a company is able to grow its top line and bottom line over a 10-year time period I try to compare that against competitors to see how it stacks up.

Payout Ratio

I then look at the dividend payout ratio against both earnings and free cash flow, and compare it against the historical payout ratio. I usually invest in companies that have ample coverage of the dividend through both earnings and FCF. A quick check of the dividends per share against earnings per share can give you an idea of whether or not future dividend growth can continue, and looking at a simple payout ratio like this I try to make sure the number is 80% or lower.

Now I prefer a much lower number, and I usually try to invest in companies with payout ratios of 60% or lower. Typically speaking, the higher the yield the higher the payout ratio will be, and vice versa for lower yielding stocks. As such, I'm willing to work with a higher payout ratio that you'll sometimes find with higher yielding tobacco, telecommunications and utility stocks. However, keep in mind that the higher the payout ratio the less likely you'll see big dividend raises in the future as it limits how much the company can raise its dividend over time. That's why higher yielding stocks usually have lower dividend growth rates. I also want to make sure that free cash flow can cover the dividend amply when looking at the company over a 10-year time frame. Dividends are paid in cash, and so you want to make sure the company has the cash flow to cover its payout.

Debt

I also look at debt during the quantitative analysis phase. A large amount of debt can limit a company, much the same as it can limit you or I. If a company is busy spending cash on debt obligations that means it has less cash to send my way as a shareholder. As such, I try to invest in companies that have low debt obligations. I first look at the debt/equity ratio, meaning I'm looking at how much long-term debt a company carries when measured against total shareholder equity in the company. I personally view any ratio of 1:1 as acceptable, and a number lower than that is attractive. However, it's important again to compare the company you're analyzing against the competition. You'll typically see manufacturing companies, utilities and telecoms carry higher amounts of debt against equity because of the need to finance certain large-scale projects and they typically have an asset-heavy infrastructure. On the flip side, you'll usually see low debt/equity ratios with many consumer discretionary and staple companies because they don't have as much infrastructure. For instance, a company manufacturing jet engines will need more infrastructure than a company making cookies.

However, I don't want to invest in a company that is only financing its growth through debt. While leveraging can lead to outsized returns when used right, over-leveraging can be dangerous. Obviously, if a company can generate shareholder returns greater than the interest rate they're paying on debt then this can be a great tool to reward owners in the company. However, it's important as well to not load up the balance sheet too heavily as this debt will eventually have to be paid and this can limit the use of cash in the future.

Another ratio I like to look at when analyzing a balance sheet is the interest coverage ratio. This is calculated by dividing a company's earnings before interest and taxes (EBIT) by the interest expenses. You'll want to use the same time period for both numbers to make it accurate. Any number lower than one indicates a company does not generate enough revenue to cover interest expenses. So the higher the number, the better. I typically want to see a number above five, but this isn't set in stone.

Return On Equity

Another important metric is return on equity. ROE can be calculated by dividing net income by shareholder's equity. ROE will show us how much profit a company generates with shareholder equity. This is a more general metric to determine profitability of a company. While the higher the better, I don't aim for specific numbers here. However, I do want to make sure the company is seeing stable returns on equity, as a declining ROE shows a negative trend in profitability. Again, I try to compare apples-to-apples by looking at the competition within the same industry.

Yield

This is an easy metric to find and compare against not only other companies within the same industry, but all other investments available to an investor. As someone who is trying with everything I've got to acheive financial independence by way of living off the dividend income my investments provide, the higher the entry yield on an investment the more income I can receive, and therefore the quicker I can acheive early retirement. However, higher yield will sometimes have trade-offs like lower growth or perhaps more risk. After four years of active investing in equities, I've found it unproductive and risky to chase yield. I usually find the investment opportunities with the greatest potential total return are the equities that yield 3% to 4% with growth rates of the dividend in the 7% to 10% range. Many dividend growth investors call this the "sweet spot", and for good reason. Chasing a stock yielding 8% won't get you very far if the dividend can't grow, or is cut, and the stock price languishes or falls. You'll find that the bulk of my portfolio is invested in companies that fall squarely in the aforementioned sweet spot - companies like Johnson & Johnson (NYSE:JNJ), PepsiCo, Inc. (NYSE:PEP) and Philip Morris International (NYSE:PM).

Valuation

Once I determine a company is worthy of investment because of solid fundamentals like low debt, high ROE, solid growth rates and a low payout ratio I then have to actually value the stock. I'm typically first going to look at the price/earnings ratio here (P/E), because this is a fairly standardized metric that can be compared against not only other companies within an industry, but companies across all other industries as well as the broader stock market as a whole. I try to limit my purchases to those stocks that have P/E ratios less than 20, generally speaking. In my opinion, one of the most important things you can do when looking at the P/E ratio is comparing the current ratio against a company's historical P/E ratio to see if today's prices are within reason. I usually compare today's P/E ratio to the 5-year average so that the numbers can be smoothed out and compared. While a P/E ratio of 15 may seem attractive when compared to the 100+-year Shiller P/Eaverage, if a company is typically valued by the market with a P/E ratio of 11 you might not be getting a cheap stock.

I also tend to look at the price/book, price/sales and price/cash flow metrics here, and while I'm not looking for specific numbers I use these for comparative purposes against industry standards.

This is also where I value a company using a typical Dividend Discount Model analysis. There's a number of ways you can quantitatively boil a company's valuation down to a reasonable range, and a DDM, as well as a Discounted Cash Flow analysis, is fairly popular and certainly viable. A DDM tries to to predict all future dividend payouts by a company and discount them back to present value. Since any company is only worth all the future cash it can generate, looking at the shareholder return via dividends is certainly a reasonable way to value a company. The most simplistic representation of the DDM is to divide dividends per share by what you get after subtracting the dividend growth rate from the discount rate. However, I use the spreadsheet that Matt Alden from Dividend Monk developed because, frankly, it's quicker, easier and just plain looks good.

When using a DDM I use a 10% discount rate, because that's the return I'm after. Your discount rate is essentially the annual return rate you're trying to achieve. A 10% rate of return on equity across an entire portfolio is a solid risk-adjusted return, in my opinion, and within reason of what the stock market hasreturned historically. Furthermore, it's of my opinion that anyone seeking financial independence does not need superhuman returns in the stock market to acheive FI, or early retirement.

After accounting for my discount rate I then have to factor in the growth rate of the current dividend. This is obviously a little art and a little science, since nobody can predict the future. What I do to reasonably estimate the long-term dividend growth rate is look at the historical EPS growth and dividend growth rate the company has been able to achieve over the last 10 years and project that out over the long haul with a margin of safety. By that, I mean if a company has been able to grow earnings by 8% and the dividend by 9% over a fairly substantial period of time I might predict the growth rate at 7%, which is less than both numbers. Furthermore, a company growing the dividend faster than earnings can only do so by expanding the payout ratio so you'll want to look at both earnings and dividend growth to be able to reasonably estimate the dividend growth looking out over the long haul.

Part II - Qualitative Analysis

This is the art side of valuating a company. The qualitative analysis phase is where I look at qualitativeaspects of a company - meaning they can't be easily quantified, but still have substantial merit, as well as a significant effect on the valuation. This phase of analysis is where I ask myself what the company in question does. How do they make money? Is it reasonable to conclude that they'll be able to keep making money in the future using the current business model? Do people like their products? Why or why not? Are the products or services the company produces or provides worth a premium they may or may not charge? Do they have a good reputation? What's the competitive landscape like? Is there a favorable or unfavorable regulatory environment? Is the company diversified, or do they overly rely on one product or service? Are they able to transform themselves when necessary?

Economic Moat

A term coined by Warren Buffett (Trades, Portfolio), it's important to look at every company as a castle. And around this figurative castle is a moat. And it's this moat that protects the business against the hoards of marauding competition from destroying the castle. The bigger the moat, the more likely it is that a company will be viable and profitable for many years to come.

Competitive Advantages

Typically speaking, when trying to determine the size of an economic moat we're looking at competitive advantages. When I'm analyzing a company for competitive advantages I pour over the annual report which gives management an opportunity to explain to me, as a potential shareholder, exactly what the competitive advantages that the company may or may not possess.

When I think of competitive advantages I think of anything that gives a company a leg up on the competition. And competition is not only the companies that are actually out there doing business, but also companies that could potentially be conceived at any time.

Economies Of Scale

So when pouring over annual reports I look for advantages like economies of scale, which provides a company increased profitability with increased production by way of lower per-unit fixed costs. For instance, it would be incredibly difficult for a new beverage company to compete with The Coca-Cola Company (NYSE:KO)because Coca-Cola is able to produce its beverages at very low costs because it's bottling huge amounts of liquid at a time. This allows Coke to buy raw materials at very cheap rates because it's buying everything in massive bulk. A new beverage company, on the other hand, will not have this type of negotiating power and, therefore, will see its input costs rise and the cost to manufacture every bottle rise.

Being a low-cost producer is another advantage of having significant economies of scale. Wal-Mart Stores, Inc. (NYSE:WMT), for example, is well-known for their ability to stifle competition because they're able to supply the market with cheaper goods than the retailer next door. They're able to negotiate with the product manufacturers because of the ubiquitous nature of their stores. With a massive supply chain and storefronts seemingly everywhere, Wal-Mart can supply consumers with products lower costs. As such, this is a difficult economic moat to conquer.

Furthermore, economies of scale also allow a company to negotiate other aspects of the business. For instance, they may be able to get bigger loans with smaller interest rates, which would allow them to potentially acheive higher returns for the shareholders than what a smaller company could.

[/b][b]Distribution

Another big advantage is distribution networks. Take Coca-Cola again. Their products are available in over 200 countries. This gives them not only an advantage against potential upstarts, but against all other businesses they compete against right now in almost every country in the world. Since their product is ubiquitous, it's easy to know exactly what you're going to get when you open a bottle of Coca-Cola or anything else they manufacture and sell. Furthermore, this type of geographical diversification allows them to participate in markets all over the world which allows the company to smooth out growth over time simply because some markets will be growing faster than others.

Brand Name

Keeping with our Coca-Cola example, can you think of a company with a more well-known brand name? This brand power is a huge advantage over rivals, because it allows the company to maintain a certain pricing power. Remember those old ads that showed you could buy Coke for a nickel? Well, like any high quality product Coke costs a lot more these days. And you can be assured that it will cost more 10, 20 and 30 years from now. High quality, brand name products have inflation protection built right in because once people get used to using a product they're likely to keep using it. Brand loyalty allows companies like Coke to pass along input cost increases to customers, along with any price increases that otherwise warranted by business demands. And I think this is realistic. As a consumer myself, I don't expect the price on things to stay the same forever. We all know prices go up. So it's no surprise when the price of Coca-Cola is more expensive today than it was a decade ago, and as such people are inclined to keep buying it. Especially when the price of everything else goes up with inflation.

Barriers To Entry

All of the previous competitive advantages are barriers to entry in themselves, but sometimes you actually have significant industry-specific barriers to entry that makes it even more difficult for the competition to overcome a moat. Railroads are a great example of this. I'm invested in Norfolk Southern Corp. (NYSE:NSC) not because it has a brand name product, but because it's just about impossible for another railroad to start up and compete. The railroad track that's already laid out in the United States is likely all the track you'll ever see. And so the barriers to entry in this business are extremely high. Even if a company could manage to build new track, which is nigh impossible, you'd have huge start-up costs that would require massive capital and make any venture extremely unprofitable right from the get go. As such, the existing railroad companies are a great investment on fixed assets that are very valuable.

High Switching Costs

This is another competitive advantage that a high quality company can employ, and when used correctly can be extremely effective without even really trying. This particular advantage is one reason I've invested in International Business Machines Corp. (IBM). Once a particular business decides to integrate IBM solutions within their IT infrastructure, it can be quite difficult to switch to another provider. This gives IBM a built-in advantage which is quite easy to maintain as long as they continue to provide the services and solutions they promised in the first place. As such, recurring revenue sources can be easily built and maintained.

Margin of Safety

One final piece of the puzzle is trying to build a margin of safety into the valuation of a stock. While a company can have great fundamentals and solid competitive advantages, as I said earlier you don't want to overpay for a stock because it can lead to poor returns over the long haul. And although I would argue it's hard to overpay for really high quality companies, why overpay if you can get a stock for an attractive price?

I try to build my margin of safety into my valuation in two ways. First, as I discussed above I try to use a conservative growth rate when valuing a stock using the DDM. Second, I then try to buy a stock for a price less than what my DDM analysis determines is fair value.

For instance, I published my recent purchase of shares in Target Corporation (NYSE:TGT). Now I used a Dividend Discount Model to reasonably value shares using a 10% discount rate and a 8% long-term dividend growth rate. I used this 8% number even though EPS has a compound annual growth rate of almost 9% over the last 10 years and the dividend has grown at a CAGR of over 18% during this same time period. The input led me to determine that it's reasonable to assume that TGT shares are worth upwards of $93. But I didn't pay that much; I bought shares for only $62.50.

This is building a margin of safety in action. You see, you want to minimize risk as much as possible when investing in stocks. And one great way to minimize risk is to buy as far below a reasonable fair value range as possible. This way, even if you're input is flawed or the company faces unexpected trouble which causes growth rates to skew downward you still stand a chance of making money, or at the very least not losing very much. You can't determine the future, and valuing stocks is not an exact science. You're using past numbers to gauge future growth, which can be quite difficult and sometimes in accurate. Therefore, you want to be quite conservative when valuing, and then buying, stocks. A margin of safety is conservatism in action.

Part III - Tools To Use

I'm going to conclude this article with tools I personally use to analyze and value stocks.

One tool I use quite often is Morningstar - a free website that includes the past 5 years of cash flow statements, balance sheet information and income statements for free for most publicly traded companies. Morningstar also gives you the current P/E ratio against the 5-year average by clicking the Valuation tab at the top of the page. Furthermore, I like to compare the fair value I come up with for stocks against what their professional analysts determine. I use their numbers to concentrate my valuation and this gives me an idea of where I stand.

Another tool I use is S&P Capital IQ analyses, which are free through my brokerage. S&P Capital IQ provides 10 years of financial data for most companies, a fair value calculation from one of their professional industry-specific analysts (typically using a DCF model) and a short synopsis on their view of the qualitative aspects of the company. I compare this against what Morningstar and I come up with for fair value and this further allows me to concentrate my value and determine if my numbers are way off. If I'm way off from what professional analysts value a company's stock at I try to determine why. Maybe I was a bit more conservative or aggressive in my assumptions, but I tend to ultimately stick with what I conclude after a lengthy analysis session.

Finally, what I most like to use is a company's own investor relations site. This is a fantastic tool to analyze a company, especially the qualitative aspects as the annual report gives management a chance to really show where the company is going and how they're going to get there. You can usually find quarterly reports and conference calls on these sites, and this allows you to compare the financial statements you may find on some of the above third party sites to double check the results. I personally love reading annual reports and comparing them against older annual reports to see if management is living up to expectations. Although annual reports are rightly biased, I still think it's a great way to read about what a company is doing to position themselves for future profitability.

Conclusion

Tying it all together, I basically try to determine if the fundamentals look great. I want to invest in companies with low leverage levels, and if the debt is a little higher than I might like I want to at least make sure the company is getting satisfactory returns for shareholders on that debt. I look for low payout ratios on both earnings and FCF, which should ensure solid dividend growth in the future. I want a company that is able to grow, because without top line and bottom line growth the company will eventually lose the capability to grow the dividend payout. And when looking at yield, I usually shoot for companies that have a solid entry yield, but also grow the dividend at levels far above inflation which ensures me that my purchasing power will only increase over time.

Once I determine that the fundamentals are sound, the yield is right and the growth is there I take a look at the competitive advantages a company has. Do they have economies of scale? Are they a low-cost producer? Do end-users like their products and/or services? What's the barriers to entry which will limit competition?

If I conclude that a company is both quantitatively and qualitatively attractive I then value shares using a DDM analysis and try to build in a margin of safety both with the growth rate I use and the ultimate price I attempt to pay for the stock.

Full Disclosure: Long PEP, JNJ, PM, KO, WMT, NSC, TGT

I hope you enjoyed this post! This is a piece I've been thinking about putting together for some time now, but for one reason or another never got around to it. What do you think? Do you analyze and value dividend stocks in a similar manner?

Question - JNJ traded toward the expensive side based on my valuation metrics (simple example is a P/E over 20 and what I saw as limited growth). I sold not because the dividend was threatened but because I thought the stock price already baked in the next few years of operational success. With the proceeds I hope I bought similar dividends with more margin of safety (ie Chevron). My margin of safety felt threatened with JNJ - but this was short term, I recognize.

I have followed Buffetts model of "buying forever" with some stocks. Do you hold your buys thru periods of relative "overvaluation" or sell if you find a stock with a similar dividend story and more compelling valuation?

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